Archive for July 16th, 2008

This is a question which I ask quite often- Why didn’t ECB adopt an inflation targeting framework? It is not easy for a current central Bank to become an inflation targeting bank as there are numerous changes in the structure. However, ECB formed in 1998 and going by the popular ideas in Central Banking then (even now), it should have been an inflation targeting CB.

The Governing Council confirmed this definition in May 2003 following a thorough evaluation of the ECB’s monetary policy strategy. On that occasion, the Governing Council clarified that, within this definition, it aims to maintain inflation rates below but close to 2% over the medium term.

So, the main objective is price stability and they have quantified price stability to give it a proper meaning. And to carry on the mon pol, it has the famous two-pillar approach – Economic Analysis and Monetary Analysis.

Despite all this, the question still remains unanswered- why not an inflation targeting centrak bank?

I cam across this excellent paper from Otmar Issing, previous Chief Economist ECB who is credited to have developed the ECB framework. In this paper he provides a fantastic history of the monetary policy and ECB.

He also asks a question similar to mine:

But, why did the ECB not vote for the concept of inflation targeting which seemed to emerge at that time “state of the art”? In short the main reasons were the following:

His answer:

Inflation targeting would have required commitment to a specific economic model or to a suite of models. Model here does not mean just a statistical forecasting model but a structural economic model that is appropriate for conducting policy exercises. To put it simply: such models were almost nonexistent for the euro area or –in the case of the ECB `s area wide model- have just come into existence, so that the uncertainty surrounding it was immense.

Given these uncertainties, the linkage between the forecast and the monetary policy response becomes less clear: inflation targeting becomes extremely complex, the “charm” of its seeming simplicity is lost, and communication becomes correspondingly difficult.

This is an obvious reason as there were hardly any model that could encompass the entire Euroarea. However, he continues:

Alongside these objections, one fundamental shortcoming of inflation targeting was a decisive factor in the ECB’s decision, namely the fact that it completely ignores the relationship – borne out by overwhelming empirical evidence – between the growth of the money supply and inflation.The models commonly used for inflation targeting are essentially models of the real economy, and thus do not assume any independent influence of monetary growth on price developments.

More generally, the modelling of the financial system is in most cases, stylized to the extreme. Financial variables are limited in number. Developments of the yield curve, risk spreads across financial assets –to mention only a few –are hardly integrated.

Hence, inflation forecasts, produced by these econometric models, cannot provide a full picture for monetary policy purposes. The question that remains, therefore, is why central banks should rely for their assessment of current conditions and future inflation solely on models that completely disregard this important relationship between money and prices. In an inflation targeting framework it is moreover almost impossible to take adequate account of developments in asset prices.

The third point reminded me of my previous post where I pointed to an article by Wolfgang Munchau. Munchau said the main problem in today’s times is that Central Bank models use the New Keynesian theory which ignores money,credit and financial markets. Issing also talks about the same.

As a result, ECB adopted the 2 pillar approach which tries to incorporate more information before taking a policy stance:

In a nutshell the economic analysis or pillar spans a wide range of indicators and models. In the short to medium term, prices are determined by non-monetary factors such as wages (unit labour costs), the exchange rate, energy and import prices, indirect taxes, etc. Indicators of developments in the real economy include data on employment and unemployment, data from surveys, incoming orders, and so on. This economic analysis also encompasses financial sector data such as the yield curve, stock prices and real estate prices. Asset price trends can yield information e.g. on how the wealth effect is expected to influence the growth of demand of private households.

So, these are the reasons why ECB did not adopt IT and instead adopted the 2 pillar framework.

Now, in India the debates are centred on whether India should have an IT framework? Most people believe it should. They should read Issing’s paper carefully to understand the issues fully. Moreover, the recent developments do tell you that IT framework is indeed too narrow.